Posts Tagged ‘10K Bear’

Today’s idea is a little complicated, but it involves an important part of any prudent investment strategy. Market crashes do come along every once in a while, and we are eight years away from the last one in 2008. What will happen to your nest egg if it happens again this year?

Options can be a good form of market crash insurance, and it is possible to set up a strategy that might even make a small gain if the crash doesn’t come along. That possibility sets it apart from most forms of insurance which cost you out-of-pocket money if the calamity you insure against doesn’t occur.

Terry

How To Protect Yourself Against a Market Crash With Options

There are some strong indications that the old adage “Sell in May and Go Away” might be the appropriate move right now. Goldman Sachs has downgraded its outlook on equities to “neutral” over the next 12 months, saying there’s no particular reason to own them. “Until we see sustained signals of growth recovery, we do not feel comfortable taking equity risk, particularly as valuations are near peak levels,” the firm said in a research note.

For several months, Robert Shiller has been warning that the market is seriously overvalued by his unique method of measuring prices against long-term average p/e’s. George Soros is keeping the bears happy as well, doubling his wager against the S&P 500. The billionaire investor, who has been warning that the 2008 financial crisis could be repeated due to China’s economic slowdown, bought 2.1M-share “put” options in SPY during Q1. The magnitude of his bet against SPY is phenomenal, essentially 200 million shares short. Of course, he almost always deals in stratospheric numbers, but the size of this bet indicates that he feels pretty strongly about this one. He didn’t become a billionaire by being on the wrong side of market bets.

So what can you do to protect yourself against a big tumble in the market? We are setting up a bearish portfolio for Terry’s Tips subscribers, and this is what it will look like. It is based on the well-known fact that when the market crashes, volatility soars, and when volatility soars, the Exchange Traded Product (ETP) called VXX soars along with it.

Some people buy VXX as market crash insurance (or its steroid-like cousin, UVXY). Over the long run, VXX has been a horrible investment, however, possibly the worst thing you could have done with your money over the past six years. It has fallen from a split-adjusted $4000 to its present price of about $15. It has engineered 1-for-4 reverse splits three times to make the price worth bothering to trade. The split usually occurs when it gets down to about $12, so you can expect another reverse split soon.
An option strategy can be set up that allows you to own the equivalent of VXX while not subjecting you to the long-run inevitable downward trend. When volatility does pick up, VXX soars. In fact, it doubled once and went up 50% another time, both temporarily, in the last year alone. While it is a bad long-term investment, if your timing is right, you might pick up a windfall. Our options strategy is designed to achieve the potential upside windfall while avoiding the long-term prospects you face by merely buying the ETP.

Our new portfolio will buy VXX 20Jan17 15 calls and sell fewer contracts in short-term calls. Sufficient short-term premium will be collected from selling the short term calls to cover the decay on the long calls (and a little bit more).

This portfolio will start with $3000. The entire amount will not be used at the outset, but rather be held in cash in case it might be needed to cover a maintenance call in case the market moves higher.

Here is what the risk profile graph looks like with those positions as of June 18th after the short calls expire:

VXX Better Bear Risk Profile Graph May 2016
You can see that the portfolio will make gains no matter how high VXX might go. It will make a small gain (about 8% for the month) if the stock stays flat, and starts losing if VXX moves below $14.50. If it falls that far, we might sell call or two at the 14 strike and incur a maintenance requirement which would be partially offset by the amount we collected from selling the call(s). A trade like this would reduce or eliminate a loss if the ETP continues to fall, and it might have to be repeated if VXX continues even lower. At some point, some long calls might need to be rolled down to a lower strike to eliminate maintenance requirements that come along when you sell a call at a lower strike than the long call that covers it.

The above positions could be put on for about $2800. There would be about $200 in cash remaining for the possible maintenance requirement in case one might be necessary.

You probably should not attempt to set up and carry out this strategy unless you are familiar with options trading as it is admittedly a little complicated. A better idea might be to become a Terry’s Tips Insider and open an account at thinkorswim so that these trades could automatically be made for you through their Auto-Trade program.

Every investment portfolio should have a little downside insurance protection. We believe that options offer the best form for that kind of insurance because it might be possible to make a profit at the same time as providing market crash insurance.

As with all forms of investing, you should not be committing money that you truly cannot afford to lose.

This week I came to the conclusion that the market may be in for some trouble over the next few months (or longer). I am not expecting a crash of any sort, but I think it is highly unlikely that we will see a large upward move anytime soon.

Today, I would like to share my thinking on the market’s direction, and talk a little about how you can use calendar spreads to benefit when the market (for most stocks) doesn’t do much of anything (or goes down moderately).

Terry

How to Make Gains in a Down Market With Calendar Spreads

For several reasons, the bull market we have enjoyed for the last few years seems to be petering out. First, as Janet Yellen and Robert Shiller, and others, have recently pointed out, the S&P 500 average has a higher P/E, 20.7 now, compared to 19.5 a year ago, or compared to the 16.3 very-long-term average. An elevated P/E can be expected in a world of zero interest rates, but we all know that world will soon change. The question is not “if” rates will rise, but “when.”

Second, market tops and bottoms are usually marked by triple-digit moves in the averages, one day up and the next day down, exactly the pattern we have seen for the past few weeks.

Third, it is May. “Sell in May” is almost a hackneyed mantra by now (and not always the right thing to do), but the advice is soundly supported by the historical patterns.

The market might not tank in the near future, but it seems to me that a big increase is unlikely during this period when we are waiting for the Fed to act.

At Terry’s Tips, we most always create positions that do best if the market is flat or rises moderately. Based on the above thoughts, we plan to take a different tack for a while. We will continue to do well if it remains flat, but we will do better with a moderate drop than we would a moderate rise.

As much as you would like to try, it is impossible to create option positions that make gains no matter what the underlying stock does. The options market is too efficient for such a dream to be possible. But you can stack the odds dramatically in your favor.

If you want to protect against a down market using calendar spreads, all you have to do is buy spreads which have a lower strike price than the underlying stock. When the short-term options you have sold expire, the maximum gain comes when the stock is very close to the strike price. If that strike price is lower than the current price of the stock, that big gain comes after the stock has fallen to that strike price.

If you bought a calendar spread at the market (strike price same as the stock price), you would do best if the underlying stock or ETF remained absolutely flat. You can reduce your risk a bit by buying another spread or two at different strikes. That gives you more than one spot where the big gain comes.

At Terry’s Tips, now that we believe the market is more likely to head lower than it is to rise in the near future, we will own at-the-money calendar spreads, and others which are at lower strike prices. It is possible to create a selection of spreads which will make a gain if the market is flat, rises just a little bit, or falls by more than a little bit, but not a huge amount. Fortunately, there is software that lets you see in advance the gains or losses that will come at various stock prices with the calendar spreads you select (it’s free at thinkorswim and available at other brokers as well, although I have never seen anything as good as thinkorswim offers).

Owning a well-constructed array of stock option positions, especially calendar spreads, allows you to take profits even when the underlying stock doesn’t move higher. Just select some spreads which are at strikes below the current stock price. (It doesn’t matter if you use puts or calls, as counter-intuitive as that seems – with calendar spreads, it is the strike price, not whether you use puts or calls, that determines your gains or losses.)

The market experienced its worst week of 2012 on the back of a worse than anticipated unemployment report.

The S&P 500 fell 1.6% to 1,369.10, extending its weekly drop to 2.4%. The Dow slumped 168.32 or 1.3%, to 13,038.27 Friday.

Employers added 115,000 jobs in April, the Labor Department stated on Friday. It was the third straight month in which hiring had slowed, intensifying fears the U.S. recovery is truly losing momentum.

In addition, even a slight drop in the unemployment rate to 8.1% had a dark tone because the fall was due entirely to people dropping out of the workforce.

“The bottom line is you don’t have evidence that this economy has reached escape velocity,” said Robert Tipp, an investment strategist at Prudential Fixed Income.

Analysts had expected 170,000 new jobs in April, and the shortfall could open the door a bit wider for the Federal Reserve to step up efforts to help the economy with another round of quantitative easing.
The employment report included another ominous numbers. The participation rate, a measure of how many Americans are looking for work, fell to a 30-year low at 63.6% of the population.

But kicking the can down the road once again isn’t the ultimate answer. The economy is not growing as fast as needed and with continued woes in Europe there could be another rough road ahead. This of course is just speculation, but when stripped down to its core the economy does not look promising over the coming months.

Technical Mumbo Jumbo

The S&P pushed through 1370 and is now on track to hit 1350. If the major market index is able to push through that level I would expect to see a test of the 1290 area. However, I do expect to see a short-term bounce over the near-term only because of the oversold nature of the market. But, once that kicks back into a neutral state which might only take half a trading day, I expect the selling to start back up.

Remember, sell in May is upon us and I expect to see the historical norms to once again play out this year. One of the perks is that volatility as see by the VIX, VXX and VXN should increase which should afford some great opportunities to sell premium.

The economic calendar is light next week, but elections in Europe should stir the market pot during the early part of the week. One thing is certain next week should be very interesting…possibly the most interesting week of the year.

Over the last two weeks, the market (SPY) has fallen about 3%, the first two down weeks of 2012. At Terry’s Tips, we carry out a bearish portfolio called 10K Bear which subscribers mirror if they want some protection against these kinds of weeks. They were rewarded this time, as usual, when the market turned south. They gained 45% on their money while SPY fell 3%.

10K Bear is down slightly for all of 2012 because up until the last two weeks, the market has been quite strong. If someone invested in all eight of our portfolios, however, their net gain so far in 2012 would be greater than 50%. How many investments out there do you suppose are doing that well?

10K Bear predominantly uses calendar spreads (puts) at strike prices which are lower than the current price of the stock. Today I would like to discuss a little about the choice of using puts or calls for calendar spreads.

Using Puts vs. Calls for Calendar Spreads

It is important to understand that the risk profile of a calendar spread is identical regardless of whether puts or calls are used. The strike price (rather than the choice of puts or calls) determines whether a spread is bearish or bullish. A calendar spread at a strike price below the stock price is a bearish because the maximum gain is made if the stock falls exactly to the strike price, and a calendar spread at a strike price above the stock price is bullish.

When people are generally optimistic about the market, call calendar spreads tend to cost more than put calendar spreads. For most of 2012, in spite of a consistently rising market, option buyers have been particularly pessimistic. They have traded many more puts than calls, and put calendar prices have been more expensive.

Right now, at-the-money put calendar spreads cost more than at-the-money call calendar spreads. As long as the underlying pessimism continues, they extra cost of the put spreads might be worth the money because when the about-to-expire short options are bought back and rolled over to the next short-term time period, a larger premium can be collected on that sale. This assumes, of course, that the current pessimism will continue into the future.

If you have a portfolio of exclusively calendar spreads (you don’t anticipate moving to diagonal spreads), it is best to use puts at strikes below the stock price and calls for spreads at strikes which are higher than the stock price. If you do the reverse, you will own a bunch of well in-the-money short options, and rolling them over to the next week or month is expensive (in-the-money bid-asked spreads are greater than out-of-the-money bid asked spreads so you can collect more cash when rolling over out-of-the-money short options).

The choice of using puts or calls for a calendar spread is most relevant when considering at-the-money spreads. When buying at-the-money calendar spreads, the least expensive choice (puts or calls) should usually be made. An exception to this rule comes when one of the quarterly SPY dividends is about to come due. On the day the dividend is payable (always on expiration Friday), the stock is expected to fall by the amount of the dividend (usually about $.60). Since the market anticipates this drop in the stock (and knowing the specific day that the stock will fall), put prices are generally bid higher in the weeks before that dividend date.

This bottom line is that put calendar spreads are preferable to call calendar spreads for at-the-money strikes (or even at strikes slightly higher than the stock price) coming into a SPY dividend date. Even though the put spreads cost more, the Weekly options that can be sold for enough extra to cover the higher cost. You do not want to own SPY call calendar spreads which might become in the money on the third Friday of March, June, September, or December because you will have to buy them back on Thursday to avoid paying the dividend, and you may not want to make that purchase to keep your entire portfolio balanced.

Most of the time, we talk about the wonderful aspects of investing in options. I am proud that the new strategy we set up five weeks ago has now had five consecutive weeks of gains (averaging over 5% a week), but today I would like to discuss some of the negatives in trading options. Unfortunately, there are a few.

A Look at the Downsides of Option Investing

1. Taxes. Except in very rare circumstances, all gains are taxed as short-term capital gains. This is essentially the same as ordinary income. The rates are as high as your individual personal income tax rates. Because of this tax situation, we encourage subscribers to carry out option strategies in an IRA or other tax-deferred account, but this is not possible for everyone. (Maybe you have some capital loss carry-forwards that you can use to offset the short-term capital gains made in your option trading).

2. Commissions. Compared to stock investing, commission rates for options, particularly for the Weekly options that we trade in many of our portfolios, are horrendously high. It is not uncommon for commissions for a year to exceed 30% of the amount you have invested. Because of this huge cost, all of our published results include all commissions. Be wary of any newsletter that does not include commissions in their results – they are misleading you big time.

Speaking of commissions, if you become a Terry’s Tips subscriber, you may be eligible to pay only $1.25 for a single option trade at thinkorswim. This low rate applies to all your option trading at thinkorswim, not merely those trades made mirroring our portfolios (or Auto-Trading).

One of our most popular portfolio (we call it the 10K Bear) has gained nearly 70% (after commissions, of course) in the last six months. The underlying stock for the 10K Bear is the S&P 500 tracking stock, SPY, one of the most stable of all indexes. Yet our weekly results included a loss of 34.7% in the last week of November when SPY rose $8.52 in a single week (a highly-unusual upside move). Many times over the past six months, our weekly gains were above 20%, however, when SPY fell in value during the week.

Many people do not have the stomach for such volatility, just as some people are more concerned with the commissions they pay than they are with the bottom line results (both groups of people probably should not be trading options).

4. Uncertainty of Gains. In carrying out our option strategies, we depend on risk profile graphs which show the expected gains or losses at the next options expiration at the various possible prices for the underlying. We publish these graphs for each portfolio every week for subscribers and consult them hourly during the week.

Oftentimes, when the options expire, the expected gains do not materialize. The reason is usually because option prices (implied volatilities, VIX, – for those of you who are more familiar with how options work) fall. (The risk profile graph software assumes that implied volatilities will remain unchanged.). Of course, there are many weeks when VIX rises and we do better than the risk profile graph had projected. But the bottom line is that there are times when the stock does exactly as you had hoped (usually, we like it best when it doesn’t do much of anything) and you still don’t make the gains you originally expected.

With all these negatives, is option investing worth the bother? We think it is. Where else is the chance of 50% or 100% annual gains a realistic possibility? We believe that at least a small portion of many people’s investment portfolio should be in something that at least has the possibility of making extraordinary returns.

With CD’s and bonds yielding ridiculously low returns (and the stock market not really showing any gains for the past 4 years), the options alternative has become more attractive for many investors, in spite of all the problems we have outlined above.

Last week was a bad one for the market. The S&P 500 fell 3.5%. Six of the 8 portfolios carried out at Terry’s Tips made gains last week. Once again, our subscribers where happy that they owned options rather than stock.

One of the two portoflios that lost money is not carried out with our basic strategy, but is a proxy for owning stock in AAPL (which fell over $12 last week, obviously causing a loss).

Our 10K Bear portfolio gained almost 10% for the week, and now has gone up over 70% since we started it 5 months ago (SPY has fallen 7.5% over that time period). This portfolio continues to be a good hedge against other investments which do best when markets move higher.

Today I would like to update the report I sent out last week on a $1479 investment which we believe should make 5% a week.

Update on 5% a Week “Conservative” Portfolio:

Three weeks ago, we made the following trades in one of our portfolios as a demonstration of an option play that we believe will make at least 5% a week after paying all commissions. At the time, SPY was trading just about $125:

Buy To Open 1 SPY Jan-12 132 put (SPY120121P132)
Sell To Open 1 SPY Dec2-11 125 put (SPY111209P125) for a debit of $6.98 (buying a diagonal)

Buy To Open 1 SPY Jan-12 118 call (SPY120121C118)
Sell To Open 1 SPY Dec2-11 125 call (SPY111209P125) for a debit of $7.05 (buying a diagonal)

These two spreads cost us a total of $1403 plus commissions of $5 (the commission rate for Terry’s Tips subscribers at thinkorswim). It is an interesting option play because the deep in-the-money Jan-12 put and call together will be worth at least $1400 (their intrinsic value) when they expire on the third Friday in January (7 weeks after we made these trades). Since we only paid $1408 for these options, as long as we don’t have to buy back any short options we might sell against them, we are guaranteed to collect at least $1400 when they expire in January.

An interesting additional feature of this portfolio is that if the stock manages to make a big move during the 7 or so weeks of the long options’ existence, the original long put and call might be able to be sold at the beginning of the final week for well more than their intrinsic value. The closer to one of the original strike prices the stock becomes, the greater the additional time premium will be. Of course, if the stock moves outside the original range (118 – 132), the total value would exceed the original intrinsic value of $14 (again, as long as the short options continue to be out of the money).

We will have 6 opportunities to sell Weekly puts and calls using the Jan-12 options as collateral for those sales. Any money we collect from selling those options is pure profit (unless they end up in the money and we have to buy them back on the Friday that they expire).

Since the options we sold were both at the 125 strike price, one of them would have to be bought back on Friday, December 9th (unless SPY closed exactly at $125.00, an unlikely event).

As we reported a week ago, the portfolio gained 6.2% after commissions in its first week, and we started out last week being short a Dec-11 SPY 127 call (which we had sold for $1.28 and a Dec-11 SPY 126 put (which we had sold for $1.99). If we would be lucky enough for the stock to remain in the $126 – $127 range all week, the $324 we collected (after commissions) by selling these two options would be pure profit (a whopping 22% on our original investment in a single week).

The secret of success to this little strategy is in the adjustments that invariably need to be made because the stock usually doesn’t stay perfectly flat all week. Last week was no exception. SPY fell $4.46. Ouch!

When SPY fell over $2, we bought back our short 126 put and sold a 123 put which also expired on Friday, December 16. Buying this vertical spread cost us $181 after commissions, but our net cost was reduced by what we gained by selling a vertical spread on the short 127 call, replacing it with a short 124 call (this sale gained us $104 after commissions). So we had now lost $77 of the potential maximum $324 gain for the week.

On Friday, we had to buy back the in-the-money 123 put, paying out $133, and we bought back the out-of-the-money 124 call for $1 (no commission charged at thinkorswim for this trade). These trades reduced the potential maximum gain by $134. For the week, then, we gained $113, or 7.6% on the original investment of $1479 ($1408 plus an adjustment cost) three weeks earlier.

At the outset, we said that we expected this little investment would gain us an average of 5% a week, and we have exceeded that goal in each of the first two weeks. Going into the third week, we have collected $127 from selling a 121 put which expires on December 23 and $142 from selling a 122 call which expires on that same day.

If SPY ends up between $121 and $122 this Friday (and no adjustments become necessary), we could earn $269, or 18% on our original investment. (At the end of the day last Friday, these two options were worth a total of $253, so we had already picked up a paper gain of $16).

Here is the risk profile graph for our positions, indicating the loss or gain next Friday at the various possible prices for SPY. Of course, if SPY fluctuates by $2, we would make an adjustment as we did this week, and hopefully turn a possible loss into a gain (as we did last week).

If you can follow the above trades, you have a good understanding how we carry out our portfolios at Terry’s Tips. If this strategy can indeed make 5% a week (and there is the possibility of much more), we wonder why anyone would be buying stock or mutual funds rather than investing in an option strategy similar to this.

Many of our subscribers are mirroring our trades in this portfolio (or having thinkorswim make the trades for them through their Auto-Trade service). Last week they were all happy campers.
___

Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.

You can see every trade made in 8 actual option portfolios conducted at Terry’s Tips and learn all about the wonderful world of options by subscribing here. Why wait any longer to make this important investment in yourself?

This week I would like to describe an actual option play we made two weeks ago which you should be able to duplicate with no more than a $1600 investment. We believe it will make at least 5% a week for the six remaining weeks of its existence.

We are pleased that every one of our portfolios made nice gains last week. The average portfolio gained 7% after commissions in spite of fairly high mid-week volatility. We were especially happy with our bearish 10K Bear portfolio – it gained 13% even though SPY ended up going up by 1% last week. Our William Tell portfolio (using AAPL as the underlying) gained 8.7% while AAPL rose 1%.

An Interesting “Conservative” Option Purchase That Could Make 5% a Week:

Two weeks ago, we made the following trades in one of our portfolios as a demonstration of an option play that we believe will make at least 5% a week after paying all commissions. At the time, SPY was trading just about $125:

Buy To Open 1 SPY Jan-12 132 put (SPY120121P132)
Sell To Open 1 SPY Dec2-11 125 put (SPY111209P125) for a debit of $6.98 (buying a diagonal)

Buy To Open 1 SPY Jan-12 118 call (SPY120121C118)
Sell To Open 1 SPY Dec2-11 125 call (SPY111209P125) for a debit of $7.05 (buying a diagonal)

These two spreads cost us a total of $1403 plus commissions of $5 (the commission rate for Terry’s Tips subscribers at thinkorswim). It is an interesting option play because the deep in-the-money Jan-12 put and call together will be worth at least $1400 (their intrinsic value) when they expire on the third Friday in January (7 weeks after we made these trades). Since we only paid $1408 for these options, as long as we don’t have to buy back any short options we might sell against them, we are guaranteed to collect at least $1400 when they expire in January.

We will have 6 opportunities to sell Weekly puts and calls using the Jan-12 options as collateral for those sales. Any money we collect from selling those options is pure profit (unless they end up in the money and we have to buy them back on the Friday that they expire).

Since the options we sold were both at the 125 strike price, one of them would have to be bought back on Friday, December 9th (unless SPY closed exactly at $125.00, an unlikely event).

Two days after we bought the two spreads, SPY shot up to $127 (when the stock moves $2 with this strategy, we make an adjustment because we do not want any of our short options to become more than $2 in the money). These are the trades we placed:

Buy To Close 1 SPY Dec2-11 125 call (SPY111209C125)
Sell To Open 1 SPY Dec2-11 127 call (SPY111209C127) for a debit of $1.33 (buying a vertical)

Buy To Close 1 SPY Dec2-11 125 put (SPY111209P125)
Sell To Open 1 SPY Dec2-11 127 put (SPY111209P127) for a credit of $.67 (selling a vertical)

We paid out $133 to roll up the short call from the 125 strike to the 127 strike, and collected $67 when we rolled up the short put from the 125 to 127 strike. After commissions, these two trades cost us a net $71.

The stock then fell back to $125 and we reversed the last put trade (but did not bother rolling down the short call to the 125 strike, electing to let it expire worthless):

Buy To Close 1 SPY Dec2-11 127 put (SPY111209P127)
Sell To Open 1 SPY Dec2-11 125 put (SPY111209P125) for a debit of $1.11 (buying a vertical)

This trade cost us $113.50 including commissions. When we bought back the soon-to-expire short options on Friday (paying no commissions since thinkorswim does not change a commission to buy back a short option for $5 or less), we paid out another $8, making the total outlay $1600.50 ($1408 + $71 + $113.50 + $8).

At last Friday’s prices, our long Jan-12 options were trading at a total of $1705.50, indicating that we had gained $105 for the week, or 6.2% after commissions.

At the outset, we said that we expected this little investment would gain us an average of 5% a week, so for the first week, we are right on target.

For the second week, we collected a total of $324.50 by selling a Dec-11 126 put and a Dec-11 127 call which will expire next Friday, December 16th. By the end of the day, their value had fallen to $252.25, so we had already made some of the gain we expect for the second week. If the stock ends up between these strikes (126 and 127) and we don’t have to adjust mid-week, the entire amount (about 20%) could be profit.

Here is the risk profile graph for our current positions. It shows the expected loss or gain at the various possible prices where SPY might be on Friday (remember, if the stock moves by $2 in either direction, we will make an adjustment similar to those we made in the first week), and the curve will move in the direction that the stock moved. Some of the potential gain will be erased when adjustments are made.

If you can follow the above trades, you have a good understanding how we carry out our portfolios at Terry’s Tips. If this strategy can indeed make 5% a week (and there is the possibility of much more), we wonder why anyone would be buying stock or mutual funds rather than investing in an option strategy similar to this.

Many of our subscribers are mirroring our trades in this portfolio (or having thinkorswim make the trades for them through their Auto-Trade service). Last week they were all happy campers.

For the last month or so, the European debt crisis has crushed the U.S. stock market. Will fears of a global melt-down continue to depress our markets, or will we enjoy a Santa Claus rally next month?

The answer is that no one really knows. We can all wager a bet as to which way the market will go, but it really is no more than a guess. We all know the market moves both ways, but we never know which way it will move next.

I believe that some of everyone’s investment portfolio should be in a hedge that protects against the market moving down. Most people are quite eager to buy stocks or mutual funds, but very few set up a hedge in case they are wrong. Today I would like to discuss exactly how that hedge might be set up.

A Smart Way to Hedge Your Investments (With Options)

Let’s say you have accumulated a nest egg of $25,000 which you have wisely placed most of it in an index fund (I say wise because index funds, over time, consistently outperform every other kind of mutual fund investment).

Now let’s assume that you are super-smart, and have decided to take $5000 (20% of your total investment portfolio) and placed it in an investment which will prosper if the market should fall. In my opinion, that hedge should be an options portfolio much like an actual portfolio we carry out for Terry’s Tips subscribers. We call it the 10K Bear.

Four weeks ago, the market (the S&P 500 tracking stock, SPY) was at $128.60. Last Friday, SPY closed at $116.34, a drop of $12.26, or 9.5%. Presumably, your index fund lost exactly that amount. On your $20,000 investment, you have lost $1900 over those 4 weeks.

Now let’s check out how well your 10K Bear portfolio has held up. Our actual portfolio (which many subscribers mirror on their own or have thinkorswim make the trades for them through their Auto-Trade program) gained 80% after commissions. If you had invested $5000 (20% of your total investment portfolio) in the 10K Bear, you would have gained $4000 over those 4 weeks while the market tanked.

Bottom line, if you had invested 20% of your money in the 10K Bear and 80% of your money in an index fund, you would have a net gain of over 20% for the period rather than a loss of 9.5%. In fact, if you had only put 10% of your funds in our bearish options portfolio, you would have broken even for the period rather than losing 9.5%.

Here is how the 10K Bear should perform this week (ending Friday, December 2). The portfolio is currently worth $6730 but we will withdraw money again next week so that subscribers can mirror the portfolio with close to $5000:

The P/L Day column in the lower right-hand corner shows the expected gain if the stock closes as the Stk Price (left-hand corner column). You can see that an average gain of about 13% will come if the stock stays flat or falls by as much as $3. It can go $2 higher and a profit will still be made. Only if the stock goes up by more than $2 ½ should a loss result (assuming no adjustments are made).

If the stock fluctuates more than $2 in either direction early in the week, we would probably make an adjustment which would shift the above curve in the direction that the stock has moved. This adjustment would usually reduce the maximum possible gain for the week but would increase the chances that a good gain would result. Above all, we do our best to avoid a loss of any amount.

How is this portfolio set up? It consists of owning SPY puts which expire in January or February 2012 and selling Weekly puts (at lower strike prices) that expire this Friday, December 2nd. If the stock holds steady, the decay rate of our Weekly puts is greater than our longer-term long puts, and the portfolio gains from the difference in decay rates.

If the stock falls, since the long puts are at higher strike prices, they increase in value at a greater rate than the short puts do, and even larger gains are possible. If the stock falls too much, at some point the long and short put positions go up at essentially the same rate (and we would make an adjustment by rolling down some of our short puts to even lower strikes).

This may seem a little complicated to you right now, but it is a very simple strategy once you watch it unfold in the real world for a few weeks. Many subscribers mirror our portfolio on their own until they have confidence that they understand it sufficiently to carry it out on their own (and we are delighted to have an ex-subscriber who is making big bucks and will say nice things about us).

For an investment of only $79.95 (subscribe here), you can learn all the details of a hedge that could have turned the losses you incurred over the last month into gains which were twice as great as those losses. (This price includes weekly updates on the 10K Bear and 7 other portfolios for two months.) Of course, that investment gets you a whole lot more than the details on this bearish hedge. But even if there were nothing else, it is a huge bargain that you should be able to use for the rest of your life to increase your annual gains year after year (especially in those times when the market falls, as it will).

Last week was the worst week for the market in over two months. How did your stocks fare? A week ago, I showed you the risk profile graph for our 10K Bear portfolio. It spelled out what would happen at the various possible ending prices of SPY on Friday. This portfolio gained 27.7% (after paying commissions) last week. It has now gained 47% over the last 3 weeks while the stock has fallen 6%.

Our Boomer’s Revenge portfolio (which takes a neutral position on the market) enjoyed an expiration month where SPY fluctuated all over the place but ended up just about where it started. That is the ideal thing for us. This portfolio gained 45% in one month after commissions.

Where, besides options, can you make gains like this when the market is flat (or goes down)? Most investors would be happy with 40% gains for a two-year period. We did it in one month.

We take the position that we have no idea which way the market will move in the short run. However, if we really could guess its direction, we could make extraordinary gains. Today I want to check out one statistical rule of thumb that some people believe might give us an idea of short-term market direction.

Testing A Statistical Rule of Thumb

We have always held the position that we had no idea which way the stock was headed in the short run (but over time, it has gone up about 10% a year, so we should lean a bit in the upside direction). This assumption seems to have served us well over the years.

However, a time-tested rule of thumb in the world of statistics is that for almost any curve of economic activity, the direction of the change in the next period is more than twice as likely to be in the same direction as the direction of the change in the last period. This rule of thumb supposedly applies to all time periods, whether they are daily, weekly, monthly, or annually.

For sure, if you examined a moving average curve for a stock or index, every subsequent change is almost always in the same direction as the last change. Very rarely does the curve hit a bottom or top and reverse direction.

I wondered if we could use this rule of thumb to predict the direction the market might be headed based on what it did in the previous month. If more than twice the time, the change was in the same direction, we could benefit considerably by setting up risk profile graphs which had more room for the stock to move in that particular direction. If this statistical rule of thumb held true, maybe we should change our basic assumptions and the strategy as well.

To check out the idea with SPY, I checked the monthly changes in SPY over the last 10 years. In exactly 60 of the months, the stock moved in the same direction that it had in the previous month. In exactly 60 of the months, it moved in the opposite direction that it had in the previous month. A perfect tie.

The only conclusion that we could make from these numbers is that our original assumption that we just don’t know is probably about as good as we are likely to get. The statisticians are not always right when it comes to the real world, at least when it comes to monthly fluctuations of SPY.

Last week I discussed our 10K Bear portfolio, the one that is designed to do best when the market falls. Today I would like to expand that discussion and report on how well the portfolio did last week when there was extreme volatility (SPY fell over 4% on Wednesday but managed a gain of about 1% for the week).

Once again, I hope you will spend a few minutes studying the graph below. If you can see what will happen in the next few days (ending Friday, November 18th), you will have a much better understanding of why I believe that options offer more potential than just about any other investment you can make.

I hope you will make a 5-minute investment in yourself and study the graph carefully.

Follow-Up on Last Week’s 10K Bear Portfolio:

Most people own stocks or mutual funds that do best when the market moves higher. How do they make out when the market moves lower? Presumably, their portfolio value goes down. Maybe they don’t feel so badly because all of their friends have also suffered a loss as well.

But if you’re anything like me, you hate to lose money, even if all my friends are losing at the same time.

Doesn’t it make sense that some of your money should be invested in something that does best when the market moves lower? It’s called hedging. Hedge funds do it all the time. They even have named themselves after the idea.

We have set up a portfolio that is designed to do to just that. We call it the 10K Bear portfolio. Many Terry’s Tips subscribers (myself included) duplicate the trades made in this portfolio in their own account through the Auto-Trade program at TD Ameritrade’s thinkorswim. Others copy the trades on their own in their account.

The neat thing about this portfolio is that it can make gains even if the stock goes up. How many investments make gains when the stock moves in the opposite direction that you are betting on? Therein lies the magic of options trading.

Obviously, this portfolio does not make money every single week, regardless of what the market does. But it almost always makes gains if the market stays flat or falls moderately, and also can make smaller gains if the market moves just slightly higher. At the beginning of each week, we create a risk profile graph like the one below so we know exactly how the portfolio will perform at the various stock prices where it might end up on Friday.

The 10K Bear is a portfolio currently worth about $4200. We own puts at several different strike prices (between $124 and $128). These puts will expire on the third Friday in January of 2012. Against these long puts we have sold Weekly puts which will expire on November 18, 2011. These Weekly puts are at lower strike prices (from $122 to $126).

The Weekly puts that we have sold have higher decay rates than the January puts that we own (all options fall in value, or decay, every day the underlying stock remains flat). This means that every day that the market does not fluctuate, our portfolio value grows larger. That is the neat thing about a properly-designed options portfolio. You can make gains even if you are wrong. When you buy stock, the only way you make money is if the stock moves higher. With options, you can make substantial gains even if the market stays absolutely flat (or moves moderately either up or down).

Here is the risk profile graph for our 10K Bear portfolio. It shows how much the portfolio will gain or lose at the possible ending stock prices this Friday.

The second column from the right (under P/L Day) gives the dollar loss or gain at the three selected prices in the first column (Stk Price), and you can estimate the losses or gains from the graph curve at other possible stock prices. At last Friday’s close, SPY was trading at $126.66.

You can see that if the stock is absolutely the same at the close next Friday, the portfolio will gain $470, or just over 10%. If the stock falls moderately, by $2, and ends up at $124.66, the gain should be $970, or about 20%. (Both these numbers will be reduced slightly from commissions and trading costs when the Weeklys are bought back next Friday and replaced with Weeklys that expire on November 25th.)

The stock can go up as high as $128 before a loss should result. In other words, the portfolio makes excellent money if the stock stays flat, even more money if the market falls moderately, and it also can gain if the market goes up (as long as the rise is not too great).

Where else can you invest your money and expect these kinds of returns? If you know of anything that can offer even remotely as great as these gains, please send the details along to me. If you like, I would share them with my subscribers so we all could benefit.

Why are you waiting any longer before you learn the details of how you can start making money using the 10K Strategy that is the basis of the 8 actual portfolios that we carry out (and you can easily duplicate in your own account, either on your own or through the Auto-Trade program at thinkorswim)?

Give yourself (and your loved ones) an early Christmas gift, and increase your earning potential exponentially by subscribing today. Do it right here.

Success Stories

I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.

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tastyworks, Inc. and Terry’s Tips are separate, unaffiliated companies and are not responsible for each other’s services and products. Options are not suitable for all investors as the special risks inherent to options trading my expose investors to potentially rapid and substantial losses. Options trading in a tastyworks account is subject to tastyworks’ review and approval. Please read Characteristics and Risks of Standardized Options before investing in options